Posts from — August 2008

“It may still just be summer but there is a feeling of chill in the economic air. The British economy is going through a difficult and painful adjustment due to higher energy and commodity prices and in banking, credit and housing markets. This adjustment to our economy cannot be avoided and as a result, inflation is rising and growth is slowing.”

                                                                        -Gov. King-

The Monetary Policy Committee of the U.K. faces a supply side shock and a stagnating economy.  Inflation in the U.K. is the highest on record since the Second World War.  However the U.K. must deal with a deteriorating credit conditions, decreasing real income and savings, a contraction in both capital investment and retail consumption, and a -8.9% decrease in housing prices for the 2^nd quarter of 2008.  All information can be found on the Bank of England’s August 2008 Inflation report.  These combined fundamental factors have pushed the Cable from 1.983 on August 1^st to 1.867 on August 19^th.   

Technical analysis of the GBPUSD concludes that two Fib levels have been broken and that it is facing support at the .382 Fib level.  The Cable peaked at 2.116 on November 9, 2007, using this peak as a reference leads to several conclusions.  The GBPUSD was range bound between January of 2008 and July of 2008.  The range was between the .214 and .382 Fib lines, the Cable tested the range by crossing the .382 Fib level 13 times until the range was broken August 1, 2008.  After the break of the .382 Fib level at 1.959 the GBP continued on a downward spiral and lost 1,000 pips in two weeks smashing through the .5 Fib level at 1.913.  The Cable has now settled around the .618 Fib line at 1.867. 

The GBP crossed the 200 day moving average several times in late July and for the last time on July 29, 2008.  All of these factors combined with a bearish SSI indicate that the Cable could fall farther.  On top of this elections in England are set for June 11, 2009 and parliament will pressure the MPC to focus on growth rather than inflation.  The projections of the Bank of England indicate that prices will fall when growth becomes negative.  While the MPC has not formally indicated recession they have projected that a recession will contain inflationary pressures.

It is not easy for many to admit that they made an error. It seems the President Trichet might finally be starting to embark on that difficult path. After raising rates in the Euro-Zone over the protests of many top figures within that continent, Trichet finally admitted what the rest of the world had realized some time ago: the Euro-Zone’s growth prospects are weak. This announcement/confession reflects that the ECB is starting to question if it did the right thing in raising rates. By hiking interest rates, the ECB indicated that it believed that growth would not be hurt too much by their inflation-targeting movements. It seems as though they were mistaken.

While admitting a mistake is a rarity for many, it seems that is even less frequent for public figures. Powerful men and women at the top of their fields have usually ended up there by making correct decisions, and so the idea of messing up can seem foreign. However, with the future health of the European economy largely riding on the ECB’s next move, it is time to these men and women to bite the bullet and cut rates. By alleviating this pressure the ECB will, among other things, send the message that they take growth very seriously and are committed to the economic prosperity of the European Union.

While inflation is very important, the ECB should currently direct its focus towards growth. Inflation targeting is not a cure-all, and if attacking inflation includes the ruin of the Euro-Zone’s economy, then that does not strike me as very helpful.

Upcoming Figures
EUR German Gross Domestic Product (2Q)
EUR German Consumer Price Index (Jul)
EUR French Gross Domestic Product (2Q)
EUR Euro-Zone Gross Domestic Product (2Q)
EUR Euro-Zone Consumer Price Index (Jul)
USD Consumer Price Index (Jul)
NZD Retail Sales (Jun)

         The Dollars resurgence can be attributed to a variety of factors European stagnation, oils collapse, or better yet Michael Phelps.  The most important factor is that the USD is considered the lesser of two evils in regards to economic health.  Governor King came out and expressed that the down side risks of recession outweighed the future risks of inflation.  Hence the massive sell off of the Cable this morning across the board.  The pound yen moved nearly 400 pips over night while the GBPUSD fell off a cliff because expectations were being priced in the market.  However the Euro and the pound did not fluctuate against each other.  Why?  Both economies are expected to head into recession soon.  Even if the US economy is in no way considered expansionary its future is much less bleak than the EZ.  Tomorrows report could smash the euro bulls if EZ GDP disappoints and comes in worse than expected.

So a week ago, I wrote that the US Non-Farm Payrolls was the event “for all the marbles.” That was true, and we have seen the US Dollar continue its rally through this week largely on the back of that news. However, within the span of one hour tomorrow, there are two news events that are likely to have a similarly large impact. Tomorrow two of the largest central banks in the world are announcing their interest rate decisions. The announcements by the Bank of England (7:00 AM EST) and the European Central Bank (7:45 AM EST) come at the end of a week with similar announcements of four major central banks, the other two being the Reserve Bank of Australia and the US Federal Reserve.

While neither is expected to make a move, the possibility exists for both, in particular for the ECB. Though it is possible that they may hike rates (and probably preferable if you ask people such as my colleague John), it is seen as unlikely. Growth throughout the Euro-Zone has been slowing rapidly, with some member nations (e.g. Denmark) already in a recession. As such, a move that could further damage growth rates is seen by most experts as unlikely, regardless of the ECB’s general tendency to focus on inflation.

Beyond the importance of the two decisions, their proximity in time should also prove for extremely volatile markets. The USD has witnessed an excellent rally for several weeks now, and with oil experiencing a coinciding plummet in price, that trend could very well continue. With many now predicting that the USD could break out of its trend with the EUR, a surprise move by the ECB could be just what the doctor ordered to bring back the status quo. However, given the resistance by European leaders to the last rate cut, it is within the realm of the possible that the ECB could witness a near coup d’état should they hike rates again.

Upcoming Figures
EUR German Trade Balance (Jun)
GBP Bank of England Rate Decision
EUR European Central Bank Rate Decision
ECB President Trichet Holds Public Press Conference

          The AUD has had a remarkable run for the past seven years, the AUD has appreciated from .48 to near parity over the past seven years.  The commodity boom has been very beneficial to the Australian economy.  Exports of iron and raw materials have caused the Aussie economy to boom.  The global slowdown will definitely hurt demand for raw materials from the land down under due to there elasticity.  This will hurt the value of the AUD which has broken the trend line and lost nearly 700 pips in the past couple of weeks.  The AUDUSD has approached the fib line of 38.2 and seems to have met a little resistance.  Consequently this Fib level was resistance in February of this year, and could become a support level.  If the AUD bounces off the Fib level then buy the bounce.  However if it goes 20 Pips past the resistance then sell the break.  The bounce will be short lived because of the macroeconomic deterioration of the Australian economy.  However for a short term range trader knowing the Fib level is crucial to trading your position.  In conjunction with the fact that the RSI is rebounding after coming very close to 30, this information would lead technical traders to be bullish AUD.  

The technical indicators all point to buy, however the long term picture is not bright.  The unemployment numbers come out this evening and any one who has traded the news knows that those releases tend to be very volatile.  If the Aussie economy surprisingly dumps jobs then expect the AUD to fall further.  For this reason I would stay out of the trade because the technical picture looks good while the fundamental picture is in divergence.  A short term trend occurred this afternoon, yet a long term reversal may be a foot.  Especially if the price of oil continues to plummet, expect the USD to appreciate across the board.  The demand slow down for Aussie raw materials comes from the global slow down of demand.  Consumption throughout the developed world has diminished because consumable income has been allocated toward energy costs.  This reallocation of consumption has forced demand for goods to decrease.  On the aggregate level consumption has not dipped but on a retail level excluding food and energy it has.  This information all leads to the conclusion that the world is headed for recession.  If the world is headed for recession it is a sufficient condition that Australia will face an economic slowdown.  The thought that the AUD could reach parity has been squashed and the recent sell off has proved this fact.  Any dovish statements from the RBA could send the AUD into a tail spin.  Given the fact that the interest rate is at 7.25% the RBA has a lot of room to cut in order to foster growth.  Even though the RBA has a target of 2-3 percent expect the Gov Stevens to become dovish and focus on growth in the time to come.

The theory of Purchasing Price Parity is hard to digest because of the fact that is so abstract and it does not apply non-tradable goods.  PPP is a theory that states all goods will cost the same across borders, because if one country charges more then consumers will change their spending patterns.  There are a number of assumptions perfect information, immediate capital flows, etc.  The theory does have relevancy in the currency market, because it can help traders distinguish over valued currencies.  The Big Mac index developed by the Economist magazine is a great way to explain the theory.  Essentially the Economist traveled the world and found out the price of a Big Mac in every country and expressed the price in dollars.  The current price of a Big Mac in America is $3.57 where as the Euro Area has a price of $5.34.  This gives the impression that the Euro is overvalued by 33 percent.  Norway has the bargain price of $7.88 for a Big Mac which is expected because Norway suffers form the Dutch disease because oil has risen so fast. 

On the other hand China, Malaysia, and Hong Kong all have Big Macs for fewer than two dollars.  Leading to the conclusion that the Yuan needs to appreciate 110 percent until equilibrium is reached.  The data confirms suspicion that Asian currencies are undervalued in order to promote their export sectors.  They do this by buying large reserves of U.S. Treasuries to increase the value of the dollar.  The Big Mac is a global commodity consumed world wide with the same ratio of pickles, onions, and ketchup which makes it a great example for PPP.  I would not base trades on Big Mac prices but it does confirm suspicions as to whether certain currencies are undervalued or not.  Thus the Big Mac index of 2008 concludes that the Euro Area is over valued and the Asian currencies are undervalued